Backgrounder: Western Grain Revenue Cap Program
What is the western grain revenue cap?
The revenue cap is a limit on the overall revenue that can be earned by the Canadian National Railway Company (CN) and the Canadian Pacific Railway Company (CP) shipping regulated grain from Prairie elevators or U.S. origins, to terminals in Vancouver, Prince Rupert, Thunder Bay as well as movements of grain up to Thunder Bay or Armstrong, Ontario destined to Eastern Canada or for export. It is based on a formula that can also be described as a limit to the average revenue per tonne for a given length of haul that prescribed railway companies, CN and CP, can earn, adjusted for the level of inflation of railway input prices.
The revenue cap was created in August 2000 by an Act of Parliament to replace maximum freight rates. Parliament agreed to let the railway companies set individual rates for shipping western grain, but required them to stay within a total revenue limit based on all western grain movements calculated by the Canadian Transportation Agency in an effort to provide some shipping price protection.
What is the role of the Canadian Transportation Agency in establishing the revenue cap for rail transportation of western grain?
The Agency is required by the Canada Transportation Act to set annual revenue cap for CN and CP, and to determine whether each cap has been exceeded or not by each railway company.
The Agency’s mandate with respect to the revenue cap and the volume related composite price index is set out in legislation. Under the law, the Agency bases its calculations on data related to price changes for railway labour, fuel, material and capital inputs.
What is the process to establish the revenue cap for rail transportation of western grain?
The revenue cap for a given crop is established in relation to a “base year”. Since 2000-2001, the Agency has adjusted each railway company’s base year revenue figure to reflect inflation, actual tonnage moved and the corresponding actual average length of haul. The Agency announces the Volume-Related Composite Price Index by April 30 before each new crop year begins on August 1.
Based on the actual tonnage moved and actual average length of haul, the Agency then determines if each railway company has come in over or under its cap. This determination is made after the crop year ends and must be announced no later than December 31 of each year.
How is the Revenue Cap calculated?
For each crop year, starting in 2000/2001, the Agency has adjusted each railway company's base year revenue figure to reflect inflation, the actual tonnage moved and the corresponding actual average length of haul. The Agency determines the level of inflation before each crop year begins and determines the actual tonnage moved and the actual average length of haul after each crop year ends.
These determinations are determined as per the Canada Transportation Act, section 151 formula [A/B + ((C - D) x $0.022)] x E x F, where:
- is the company’s revenues for the movement of grain in the base year;
- is the number of tonnes of grain involved in the company’s movement of grain in the base year;
- is the number of miles of the company’s average length of haul for the movement of grain in that crop year as determined by the Agency (column C);
- is the number of miles of the company’s average length of haul for the movement of grain in the base year;
- is the number of tonnes of grain involved in the company’s movement of grain in the crop year as determined by the Agency (column E); and
- is the volume-related composite price index as determined by the Agency (column F).
Q. What is the VRCPI?
The Volume-Related Composite Price Index (VRCPI) is predominantly an inflation index that reflects forecasted price changes for railway, labour, fuel, material and capital purchases by CN and CP, the two federally-regulated railway companies. The index is used to help determine the annual western grain revenue cap for each railway company and to subsequently determine whether each railway company has exceeded its cap.
The VRCPI is just one of the three factors in a formula the Agency uses to calculate the maximum revenue the railway companies are entitled to collect from moving western grain. The other two factors are the actual tonnage of grain that was hauled and the average length of haul during the crop year. The cap is based on adjustments to railway revenues in the base year, using those three factors.
It reflects the forecast increase in prices that the railway companies will have to pay for fuel, labour, materials and other inputs.
Q. What is the cost of capital?
Cost of capital is defined as an estimate of the total return on net investment that is required by shareholders and debt holders so that debt costs can be paid and equity investors can be provided with an adequate return on investment consistent with the risks assumed for the period under consideration. Along with other inputs, the cost of capital is used in determining the Volume-Related Composite Price Index (VRCPI), which in turn is used to determine the annual western grain revenue cap.
Changes to the Cost of Capital Methodology and the 2012-2013 VRCPI
The cost of capital is the return on investment that investors require when providing funds for capital investments and is used to calculate the VRCPI. The railway company is required to submit financial information, from which the net rail investment, the capital structure and the cost of financing can be determined.
From 2009 to 2011, a review of the Agency methodology used to determine the cost of capital was undertaken, including consultation with stakeholders. This was done as it had been five years since the last review and changes in the global economic and financial environment raised questions about the continued reliability of existing financial models. The goal of the review was to determine if there was a superior methodology or improvements that would clearly enhance the Agency's existing cost of capital methodology.
The new methodology is nearly identical to the previous methodology but differs in establishing the cost rate of equity, most notably by:
- Relying on the weighted cost rate of equity in a North American context. Previously consideration was given only to the Canadian financial market.
- Determining the market risk premium using all available reliable information, i.e. 1951 to current for the Canadian cost of equity and 1954 to current for the U.S. cost of equity.
The Role of the Pension Costs and the Multi-year Averaging Methodology in the Development of the Labour Price Index
During the 2010-2011 VRCPI determination, CP and CN each approached the Agency and raised concerns about the way the labour price index, a component of the VRCPI, is calculated. CP proposed that funding payments should be used in place of Generally Accepted Accounting Principles (GAAP) expenses for pension costs, and CN had concerns about the multi-year averaging methodology used to calculate the labour price index. The Agency consulted with Western grain participants and formal submissions were made by CN, CP, the Provinces of Saskatchewan and Manitoba, the Canadian Wheat Board, and the Canadian Canola Growers’ Association.
- that pension costs will comprise cash payments relating specifically to services rendered in that year, plus the portion of any statutory pension plan deficit payments corresponding to the amortized value of such payments over the employee average remaining service life and any pension administrative expenses incurred by the railway company;
- to clarify the interpretation of Uniform Classification of Accounts (UCA) Account 821; and
- that the multi-year averaging methodology for development of the labour price index will be discontinued and replaced by the standard price indexation methodology (single year inputs for historical values).